Understanding (and Avoiding) the "Money Illusion"

It’s no surprise that a dollar today isn’t worth the same as a dollar was 20 years ago. This is the result of inflation. Inflation plays a major role in financial planning whether you are conscious of it or not.

The money illusion refers to a cognitive bias that fails to take inflation into account. Let’s dive into what the money illusion is, how it can impact your long-term financial planning and ways to combat the money illusion.

What is the Money Illusion?

According to Seeking Alpha, money illusion (or price illusion) is the tendency to think of your income in nominal values versus real terms.¹ When you think of something in nominal terms, you fail to consider external factors such as inflation. 

Nominal value is not the same as real value. For example, the real value of two shirts might be the exact same because they cost the same to manufacture, but one might sell at a higher price point due to demand, marketing, reputation, and brand name. These external factors contribute to the real cost of the shirt. 

The same is true for your money. If you get a 5% raise at work, but inflation is 7%, you are at a net loss of 2% in terms of real value.

There are a few reasons why the money illusion continues to play a role in the way we think about financial planning. The first comes down to a simple lack of financial education. Many people don’t know the rate of inflation or don’t understand how it impacts the real value of their income. 

The second is price stickiness. Price stickiness occurs when goods and services remain the same price despite other economic factors.² These rigid prices may color our view of inflation and make it seem like we can buy the same things today as we could in the past for the same amount, even if this isn’t reflective of the overall economy. 

How The Money Illusion May Impact Financial Planning

As you can see, the money illusion is a tricky cognitive bias that, over the course of your long-term financial planning, may put you behind your goals. If you think to yourself that you need $1 million to retire comfortably in today’s real terms, what does that equate to in 10, 20, or 30 years when you are actually ready to retire? You will likely need more than $1 million to retire comfortably as you race inflation.

How to Combat The Money Illusion

Without acknowledging inflation and the real buying power of your income, you may slowly fall behind on your financial goals. But, by building out a solid financial strategy and understanding our current economy, you can combat the money illusion and understand how much money you actually need to pursue your long-term goals. 

One way to do this is to understand how inflation works and the current rate of inflation. This will help you understand how much you have to make to keep up your buying power. 

Another way to do this is to not make risky financial decisions without understanding the market as a whole. As we talked about, price stickiness might be deceiving when you look at what you can afford. Sure, you might be able to afford a new home or car, but with rising rates of inflation that item might be more expensive than it’s advertised. 

Lastly, you can work with a financial advisor to create an investment plan that hedges against inflation. The average rate of return of the S&P 500 index is about 8% per year³ and the annual rate of inflation in the US hit 6.2% in October 2021.⁴ This means that your investments may help you minimize the impact of inflation over the long term. Talk to your financial advisor about specific strategies that can help combat the money illusion and inflation.